Rotman Management — Spring 2017

58 / Rotman Management Spring 2017

placed into this risk stereotype. The research shows that many
such ‘heuristic judgments’ result in errors, poor advice, and
lower investment performance.

ANCHORING. Anchoring is the tendency for an individual to hold
a belief and then apply it as a ‘reference point’ when making
future judgments. Planners and advisors often base their deci-
sions on the first piece of information they receive — such as a
stock’s initial purchase price — and they often have difficulty
modifying their assessment of new information. For example,
when they ‘anchor’ on a losing investment as a bad experience,
they can become excessively risk- and loss-averse, resulting in
underweighting other stocks in a portfolio.

FAMILIARITY BIAS. Planners, advisors and their clients often show

a preference to own ‘familiar’ assets. For instance, they show

an inclination to invest in local securities with which they are

most familiar, thus over-weighting portfolios in domestic as-

sets. They also tend to perceive familiar assets as less risky

and earning a higher rate of return, which can result in under-

diversification in a portfolio and resulting lower performance.

TRUST AND CONTROL. An important characteristic of the client-

advisor relationship is developing a balance between trust and

control. Clients often place too much trust in planners and ad-

visors or overly allocate control about decisions to them. Con-

versely, when clients lack trust and are controlling, they are

unlikely to listen to financial advice. Financial planners must

work to establish a balanced relationship of trust and control

with every client.

The Right (and Wrong) Way to Think About Money

Leading behavioural economist and best-selling author Dan Ariely gives his two cents to the CFA Institute’s Usman Hayat

Usman Hayat: What is the ‘right way’ to think about money?

Dan Ariely: The right way is all about opportunity

cost. Every time you buy something — a cup of

coffee, a car, a house — you should be asking, ‘What

am I giving up now, and in the future, for this act of

consumption?’ Of course, an infinite number of pos-

sible other consumption choices exist. Comparing, say, apples to

oranges is simple: Nobody has ever stood in front of a fruit bowl

saying, ‘I have no idea which one I want’, because the opportunity

cost is so clear: Do you feel like eating an apple or an orange?

But with money, you’re likely to be thinking, ‘Should I buy that new

bicycle now, or put the money into my retirement fund?’ That is a

very difficult decision, because calculating opportunity cost is the

key to answering it — and doing so is not humanly possible. Even

if you tried to get a computer to simulate all of the various things

you could spend your money on, it would be extremely difficult to

figure out a true opportunity cost for each purchase you make.

Is ‘short-term vs. long-term’ the crux of the issue?

That is one of the things that makes financial decisions so difficult,

because when you think about spending money now vs. saving for

later, you’re looking at something concrete vs. something abstract.

You want that bicycle now; and retirement seems so far away. Even

if you could say to yourself, ‘This bicycle represents one entire

month’s rent’, it’s still about ‘now vs. later’. Likewise, with food, we

get tempted by what is around us at the moment, because of our

present-focused bias.

You have said we think about money in ‘multiple wrong

ways’. Please describe a few others.

One of them is relativity. Imagine you’re going to buy a car. The

cost is 30,000 Euros, and the salesperson says, ‘Hey, would you

like leather seats for an extra 2,000 Euros?’ Compare that deci-

sion with the following: You’re buying a chair for your house, and

it costs 500 Euros. The salesperson says, ‘For 2,000 Euros more,

you can get it in leather’. In the first case, you would likely think

it seemed like a good deal; but in the second, you’d think it was

a terrible idea — even though you sit down much more at home

than you sit in your car. Because of diminishing marginal returns,

the moment you spend 30,000 Euros, 2,000 looks like a small

amount; but when you’re paying 500 Euros, 2,000 more seems

almost immoral.

Another example is, we tend to not think about decisions

from scratch. Instead, we do what is called anchoring, which

means we consider our past decisions, assume that they were

reasonable, and repeat them. Yet another strange bias affects

housing. Obviously, buying a house or condo is a huge decision.

To get an idea of what they can afford, people often use an online

calculator. Then, they use the number generated by this calcula-

tor as the true amount they can afford. Just because you’ve used

an online tool, it doesn’t mean you should borrow the maximum

amount! Yet we have this idea that, ‘the calculator said this

amount is okay’. As a result, lots of people end up buying a home

that they can't truly afford — and that, of course, affects other

areas, like saving for the future.